The month of September has been quite extraordinary for the United States of America’s economy and more particularly for its financial system. In less than a week, Merrill Lynch and Lehman Brothers — iconic institutions of the American financial system — collapsed like the proverbial house of cards. No one knew how far and how fast the epidemic would spread until Henry Paulson, the American treasury secretary, announced the government’s willingness to carry out a colossal recovery plan. The announcement of the plan changed moods in Wall Street and share prices rose in stock exchanges across the world. But, the initial euphoria has dissipated quite quickly, and several economists now question the soundness of the plan.

Lehman Brothers, Merrill Lynch and similar institutions do not deserve any public sympathy. They flouted all notions of prudence in an effort to squeeze out additional profits. They issued loans indiscriminately, taking as collateral assets which were highly overpriced because of speculative bubbles. Not surprisingly, the institutions in trouble cannot now find private buyers who are willing to buy these assets at anything close to their book values. In plain language, these institutions are saddled with mountains of bad debt.

The Paulson plan was framed against this backdrop. It involves the federal government buying up hundreds of billions of dollars of securities held by those financial institutions which are about to collapse because the market value of their virtually worthless assets is far too small given the size of their liabilities. The injection of fresh capital through the “purchase” of these assets by the federal government would then enable the distressed financial institutions to stand on their own feet again.

Of course, if the volume of additional capital injected into the system is large enough, then these institutions can be nursed back to health. (But, perhaps until the next crisis?) This must have been the thought process of the architects of the plan — Paulson and Ben Bernanke, the governor of the Federal Reserve Bank. At first sight, there is no reason why the plan should not work. But then, why has there been so much opposition to it? Indeed, as I write this, it is still not certain that the US Congress will authorize the release of funds to finance this plan.

An important reason for reservations and objections raised by many is that the plan flies against a fundamental tenet of capitalism. This is the principle that economic agents must be responsible for their own actions. If institutions and individuals demand the right to take unfettered actions in the “market” to further their own narrow objectives, then they must also be held accountable for the consequences of these actions — even if they result in very unpleasant personal consequences such as bankruptcy. In other words, financial institutions in trouble do not deserve any government assistance, and certainly not if the assistance involves tax-payers’ money. As an economist remarked acidly, the Paulson plan allows “profits to be private”, but ensures that “losses have to be social”.

It is very likely that Paulson and Bernanke would both agree with the basic sentiment spelt out above. The latter has been an illustrious member of the economics faculty in Princeton, while Paulson has been a long-time practitioner of the same capitalist principles in Wall Street. However, they would argue that there are exceptional situations when agents cannot be allowed to sow as they reap. One such circumstance, they would point out, is when “systemic risks” are involved. That is, the collapse of one big institution may create very big ripples, so much so that the entire financial system is endangered. The only way to protect the system is to bail out the individual institution although its problems may have been created largely by its own past misdeeds.

This defence of government intervention cannot be rejected outright. After all, the financial system is tightly interlocked, so that there is always a possibility of a contagion effect. On the other hand, indiscriminate government intervention also has an unpleasant side-effect — it dulls incentives to follow sound business practices. For instance, if a big bank knows that the government will bail it out because of systemic risk, then it will be tempted to adopt strategies which promise large returns even if the overall risk associated with the strategy is big. So, there is a serious trade-off involved here.

Some economists do not question the need for government intervention, but question the specific form of intervention involved in the Paulson plan. They draw an analogy with procedures followed in the US during bankruptcies in other sectors. If, for instance, a manufacturing company were to go bankrupt, then the creditors will typically swap debt for equity. That is, the creditors would become part owners of the company since the latter will issue new equity shares.

However, this process normally takes a long time since the debt-to- equity ratio is determined only after protracted negotiations between debtors and creditors. So, this cannot be a feasible solution to the current financial crisis since some actions needed to be taken almost immediately. A close alternative would be for the government to be proactive and forcibly impose a scheme where some part of the debt would be given up for some equity and some long-term debt.

The adoption of such a scheme would impose a kind of penalty on institutions such as Lehman Brothers since there would be some loss of management control. So, this scheme will avoid the serious drawback associated with the purchase of bad debts — it will not encourage the pursuit of highly risky strategies by institutions. It may even be beneficial to creditors if the implementation of such schemes restores order to the financial system. And perhaps most importantly, taxpayers will not be saddled with the bad debts of financial institutions.

Of course, schemes of this kind can only be short-term solutions — very much in the nature of a fire- fighting exercise. Much serious thought has to be given to long-run solutions whose objective has to be to minimize the possibility of widespread and large fluctuations in the financial system.

It seems very likely that all capitalist countries will now seriously consider keeping financial institutions on a much tighter leash than hitherto. The form and nature of the regulatory mechanisms will certainly vary from country to country. Since this will also involve a very large regime change, it is natural that the appropriate mechanisms will only evolve over time since some degree of experimentation is inevitable. Perhaps the tighter regulation will reduce enterprise and innovation. Hopefully, it will also result in fewer bankruptcies. That would not be such a bad trade-off after all.